03 Nov 2009

RE-THINKING THE LENDER BORROWER RELATIONSHIP: USING FINANCIAL COVENANTS AS AN EFFECTIVE MANAGEMENT TOOL

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Many aspects of the future banking landscape will certainly be different from before, but in the “old banking toolbox”, there remains at least one tried and tested methodology for managing lending risk, namely the effective use of financial covenants by lenders and borrowers. In the new world, if effectively used as a management tool by both parties, financial covenants will arguably have even higher importance than before.

In brief:

Using financial covenants as an effective management tool provides the glue which binds a lender and borrower closely together in managing their respective risks during their relationship

Lenders, borrowers and their professional advisers should endeavour to ensure that the financial covenants are drafted with absolute clarity, but equally with sufficient elasticity, to nurture and safeguard the overall health of their relationship

To this end, lenders and borrowers should consider two or three tiers of financial covenants, with increasing levels of sanction for breach, but not every breach automatically triggering an event of default

Financial covenants are not just for large corporates. The principles behind using them apply equally to small- and medium-sized businesses.

Once upon a time, a company with a good business model had access to two principal sources of external capital to support and grow its business: share capital (equity) and loan capital (debt). A good business would also have access to a third form of capital, internal capital (retained profits). Management could then use these three “sources of capital” to fund the company’s future activities.

Leverage (or Gearing)
Most companies cannot source their capital from shareholders' funds alone and need some element of debt. Financial principles suggest that higher financial leverage can be both good for the business and good for the shareholders in good times, but not so good in bad times. Conversely, in good times, the absence of financial leverage may make it very difficult for a good business to grow and to take advantage of current market opportunities then prevailing. The same principles apply to operational leverage as they do to financial leverage.

Unfortunately, the global financial crisis threw into sharp focus what happens to the financial accounts of a company when the “second tap” to capital (loan capital) is switched off, the “third tap” (retained profits) moves quickly to be closed, and the “first tap" (new share capital) remains open but there is nothing available in the pipe. The global financial crisis has provided a timely moment to re-think the basic characteristics of lending by a lender to a borrower. What goes to the heart of the lender borrower relationship and drives that relationship from its inception towards a mutually beneficial arrangement and hopefully longevity?

Furthermore, in tougher market conditions, a good company should maintain a lower level of leverage to counter-balance lower levels of profitability (and, therefore, potential retained profits) and to preserve the value of shareholders' equity. Using the oft-quoted car example to explain leverage, a good business needs to be in the right gear at the right time to suit the prevailing market conditions. Permanently driving down the fast lane in top gear in all conditions and, therefore, not being able to change direction quickly if an obstruction suddenly appears is generally a recipe for an accident waiting to happen.

Management at the wheel
But how does a good company steer its business safely along "Leverage Highway"? A good management team drives a good business, but a good lender helps to drive a good management team by being available in the front or back seat with a clear view of the driver. The lender has a joint responsibility with the borrower to make the relationship a successful one. The lender will be able to nurture the relationship by agreeing a set of financial covenants which serve the interests of both parties in helping each manage their respective risks. It is important for each party fully to understand the nature of each other's business interests and, particularly, what returns and added value each earns from the relationship.

Management without committed long-term loan capital is a higher risk activity
Apart from very cashflow-strong and very cash-rich businesses, few companies with loan capital on their balance sheets could be described as financially strong businesses, if their only instrument of loan capital was "on demand" loan capital (i.e. a “current liability” in accounting terms). From a financial accounting perspective, such businesses would have to be characterised as higher risk and more inherently unstable. A lender’s commitment of only "on demand" loan capital conveys a message to the borrower that the relationship may only be short-term in nature. For the borrower’s management, obtaining committed long-term loan capital is invariably an essential component in running a successful business.

Doing committed business
Once a supplier (the lender) has won a customer (the borrower), in most cases, it is much easier for the supplier to do repeat business with the customer than go out and find a new customer. In fact, it is preferable for each party to be viewed as both a supplier and customer at the same time, which reinforces the message that the borrower is offering to supply to the lender its business by way of giving the lender the opportunity to participate by way of an investment in its loan capital.

The costs in the relationship
The cost of the lender borrower relationship is more than just the cost of funds and the arrangement fees and commitment fees payable by the borrower to the lender. A well advised borrower should be looking at the total cost of ownership of being in a relationship with a particular lender. If financial covenants are indeed the glue which binds the borrower and lender together in managing their respective business risks during the relationship, then the borrower and the lender need to be on exactly the same page when it comes to calculating the financial covenants and then analysing and interpreting their true meaning for the business going forward. The value proposition in a borrower choosing one lender over another is that the borrower perceives the first lender as having a better understanding of the borrower's business than the second and further that the borrower perceives that the first lender will be more supportive of the borrower in those times during the relationship when, as in any relationship in life, issues arise and things may become difficult and need to be sorted out.

Contractual knot between the parties
The lender and the borrower are contractually bound together by a short-form or long-form of loan facility document. This loan facility document may or may not be supported by a guarantee and/or security documents. However, what most cements the relationship between the two parties, and its capacity to be a long-term relationship, is not the availability or otherwise of good security, which can be enforced on a default or on demand. Rather, what most cements the relationship is the holy triumvirate of the following clauses and their sensible use and interpretation by each party, especially the lender:

representations and warranties, which cover the position pre-consummation of the relationship and either validate or disprove the commercial and legal due diligence carried out by the lender prior to provision of the loan capital. In short, a breach legitimately entitles the lender to end the relationship and the borrower should have no complaints if this happens;

undertakings, both positive and negative, especially the financial covenants, which should be used as tools by both parties to manage and police the changing business risks arising between them during the relationship; and

events (of default), which trigger an early termination of the relationship, whether such events are "events of default" (in the case of term loan capital) or an "on demand notice" (in the case of on demand loan capital, e.g. a bank overdraft).

Types of financial covenants
Each borrower may require a different suite of financial covenants to suit its and the lender’s particular needs. There are many examples and variations on the particular covenants that may be used, but the same general principles that lie behind them are common to all borrowers. Typical examples include:

Leverage Ratios
• Long Term Debt/Long Term Debt + Book Value of Equity
• Long Term Debt/Long Term Debt + Market Value of Equity
• Total Assets/Total Debt.

Timely provision of financial information
Not every banking relationship will require a detailed set of financial covenants set out in the facility agreement. However, even where the relative strengths and/or relative size of the lender and the borrower do not warrant financial undertakings more detailed than the timely provision of financial information by the borrower to the lender on request, this does not detract from the business merits of both parties using financial ratios as a non-contractual business tool to monitor the risks and also the overall health of their respective role in the relationship.

Financial covenants are not just for large corporates. The principles behind using them apply equally to small and medium sized businesses. The maintenance of the short- and long-term loan capital of a business is a two-way responsibility. It is clearly the primary responsibility of management to maintain accurate and up-to-date financial information about the business. However, it is also the responsibility of the lender to ensure that management does indeed maintain accurate and up-to-date financial information and, most importantly, make this available on a regular and timely basis to the lender, so that it can analyse how the business is currently doing and where it is likely to go short-term and medium-term.

Different tiers of financial covenants with increasing levels of sanction for breach
As lenders and borrowers enter a new world order of financing, it may be beneficial for lenders and borrowers to focus much more on their mutual interests in developing a strong and long-term relationship. The key to a sound lender/borrower footing is a tight focus on the delivery of accurate and timely financial information, the testing of pre-agreed financial covenants suitable for the particular business and then the effective management of the outcomes from such testing. On that basis, a breach of a financial covenant should not automatically trigger an event of default.

Lenders and borrowers should consider agreeing two or three tiers of financial covenants, with increasing levels of sanction for breach. The first tier covenants would contain easier target numbers to achieve, ratcheting up to tougher numbers for second or third tier covenants. If there were three tiers of covenant, only breach of a third tier covenant would automatically trigger an event of default, whereas breach of a first or second tier covenant would have a lesser sanction, but not trigger an event of default. Alternatively, where there were only two tiers of covenant, only breach of a second tier covenant would automatically trigger an event of default, but breach of a first tier covenant would not.

Considering this in more detail, breach of a first tier covenant might, for example, be used as a tool to give management a sharp reminder that the lender is indeed concerned and that management needs to address those concerns in the next financial period. In order to "incentivise" management not to ignore those concerns, breach of a first tier covenant might trigger an increase in the margin or the payment of an increased commitment fee, if not immediately remedied by a certain date or the next financial covenant testing date. Breach of a second tier financial covenant would be more serious and have a sanction, but not of itself trigger an event of default. Breach might trigger a further increase in the margin or a mandatory prepayment of part of the facility by a certain date (but the trigger for the event of default would be if the required prepayment was not made by the due date). Breach of a second tier financial covenant would act as a warning to management that breach of a third tier covenant might not be far away, in which case management, with the support of its lender, should then be taking more urgent steps to re-organise its sources of capital and the uses of such capital, so as to avoid the relationship reaching a point of no return towards its eventual termination. In fact, this process should sensibly have already started following a first tier covenant breach.

Conclusion
Lenders will, of course, say that the financial covenants are only as good as the financial information provided by their borrowers and that, ultimately, the lenders do not have any control over the quality of such financial information. To a large extent, this is true. However, this does take the analysis of the lender borrower relationship back its origin, which is that lenders should be seeking out relationships with companies with a good business model and, most of all, with strong management teams. With a good business model and strong financial controls in place, a borrower and lender will have the best chance of being a successful team best equipped to manage loan capital over the medium- to long-term.

During this current period of change towards a new financial world order, when lenders will go back to their basic model of lending money again and good due diligence (both before and during the life of a facility) will be at a premium, it is incumbent upon lenders and professional advisers to encourage borrowers to take even more seriously the preparation of good financial information and making this fully available to the providers of their loan capital. Lenders also need to take their share of responsibility by organising their personnel to be able effectively and profitability to review such financial information on a timely basis as and when provided by the borrower. Ultimately, both parties have the same vested interest in the importance of this financial information. Without it, there is less chance of there being a successful relationship between borrower and lender.